Market Concentration

1. Industry Concentration
How can you tell what market structure
an industry is in?
(In other words, how do you know if a business in a
monopolist, perfectly competitive, or something in between?)

2. Measuring an industry’s concentration
1. Concentration ratio
2. Herfindahl Index
If you watch “The Office” you’ve heard the about Herfindal index
in Michael’s speech to the MBA class.
Questioner: What has happened to your
Herfindahl index since the merger?
Michael: I don’t know. How is your
“nerdsayswhat” index?
Questioner: What?
Michael: That is what I thought, Poindexter.
There are two ways to
measure an industry’s
concentration. Interpreting
that will allow you to see what
market structure an industry
is in!

3. 1. Concentration ratio
The concentration measures an
industry’s concentration by examining
the share of output controlled by the
largest four firms in that industry
– This could be measured in terms of sales,
value added, or other metric
– Data are published every 5 years by the
Census Bureau in the Economic Census
Concentration Ratio

4. Hypothetical Examples:
Concentration Ratios
Let’s assume this table describes the U.S. Dog Food Industry.
Note that the largest firm had sales of $1 billion in 2006, which
was 34% of the industry.
Note that the largest four firms added together had sales of $2.7
billion in 2006, which was 92.5% of the industry.
For this industry, the Concentration Ratio would be 92.5%.
Production is heavily concentrated in the four largest firms.
Concentration Ratio

5. Hypothetical Examples:
Concentration Ratios
Let’s assume this table describes the U.S. Retail Bakery Industry.Note that the largest firm had sales of $100,000 in 2006, which
was 0.7% of the industry.
Note that the largest four firms added together had sales of
$272,000 in 2006, which was 1.8% of the industry.
For this industry, the Concentration Ratio would be 1.8%.
Production is NOT heavily concentrated in the four largest firms.
Concentration Ratio

6. Interpreting the Concentration Ratio0%
100%
40%
Perfect
Competition Monopolistic
Competition
Oligopolistic
Monopolistic
With a Concentration
Ratio of 1.8%, the
Hypothetical Retail
Bakery Industry is near
Perfect Competition
With a Concentration
Ratio of 92.5%, the
Hypothetical Dog Food
Industry is near
Monopoly
Concentration Ratio

7. There is a problem with
the Concentration Ratio
• If four firms share all output, their
Concentration Ratio is equal to
100% but they are not a monopoly
• But if one firm is the sole producer,
its Concentration Ratio is equal to
100% and it is a monopolist
Concentration Ratio

8. The Herfindahl Index
solves this problem
The Herfindahl Index is
calculated in three steps:
1. Determine the percent of output
produced by each of the largest
four firms
2. Square each of those share
3. Add all the squared numbers
Herfindahl Index

9. Hypothetical Example:
Herfindahl Index
Herfindahl Index
Let’s assume this table describes the U.S. Dog Food Industry.
Note that the largest firm had sales of $1 billion in 2006, which
was 34% of the industry. That figure squared is 1,157 (34x34).
The same calculation was made for each of the four largest firms
Those figures were then added.
For this industry, the Herfindahl Index is 2,415. We will interpret
that figure soon.

10. Hypothetical Example:
Herfindahl Index
Herfindahl Index
Let’s assume this table describes the U.S. Cat Food Industry.Note that the largest firm had sales of $1 million in 2006, which
was 79.2% of the industry. That figure squared is 6,279 (79x79).
The same calculation was made for each of the four largest firms
Those figures were then added.
For this industry, the Herfindahl Index is 6,347. We will interpret
that figure soon.

11. Interpreting the Concentration Index0
10,000
1,000
Moderate
Concentration
Acute Concentration
1,800
With a Herfindahl Index
of 2,415, the hypothetical
Dog Food Industry is
somewhat concentrated.
With a Herfindahl Index
of 6,347, the hypothetical
Cat Food Industry is
more heavily
concentrated.
Herfindahl Index

12. Hypothetical Example:
Herfindahl Index
Notice that the top
four industries each
comprise about 92%
of the industry…
But for cat food, the
largest is really
dominant
The Concentration
Ratio would look the
same for these two
industries, but the
Herfindahl Index
really shows
differences in
market
concentration
Herfindahl Index

13. Why is this important?
• For self employed/
entrepreneurs:
– It is a good idea to understand an
industry prior to entering
competition within that industry
• For others:
– It is a good idea to understand the
industry in which you are
employed

14. How is this information used?
Here is one real world application
• The US Anti-Trust Department uses the changes in
the Herfindahl Index to decide if a merger between
two companies is anti-competitive or not.
• An increase in Herfindahl Index value by 100 or level of over
1,000 is taken seriously.

15. Real World Data: What industries are
heavily concentrated?
Moderate
Concentration
Acute
Concentration
I suspect seeing
some of these
industries does not
surprise you.
Industries that are
concentrated have
market power and
are able to exploit
consumers.
In particular, you
may feel it when you
buy breakfast cereal
or printer ink. These
goods seem quite
expensive to me!
Think about industries that might
be highly concentrated.
Can you guess some
industries that appear on this list?
Click to see them.

16. Individual exercise
Please fill in the blank cells and answer the questions at the bottom.

17. About your business proposal
Please note that for your business
proposal (and Mini Project #5), you
are required to determine the type
of market structure you will be
competing in.
You may calculate either the
Concentration Ratio or the
Herfindahl Index (or both).

18. How do I determine industry concentration
for my proposed business?!
Go to Google and type in the following:

19. How do I determine industry concentration
for my proposed business?!
Make sure you use data
from 2007
Select “AFF” for the
industry in which your
business will compete.*
*If you need help identifying your industry,
please ask me.
Let’s assume I am proposing a
business that will sell brick and stone
wholesale.

20. How do I determine industry concentration
for my proposed business?!
Once there, search
for “concentration
ratios”. Look up your
industry’s
concentration ratio
based on its NAICS
code.
Look for the 4 largest
firms.
Then find the
Concentration ratio.
Here it is 24.4.
That means the 4
largest firms make
up 24.4% of the
industry.

21. Interpret the Concentration Index0%
100%
40%
Perfect
Competition
(0%-5%)
Monopolistic
Competition
(5%-40%)
Oligopolistic
(40%-90%)
Monopolistic
(95%+)
Brick Stone
and related
merchandise
wholesalers
(24.4%)
Once you have obtained the concentration ratio, use the
spectrum below to interpret your business’ market structure
Note that these percentages are estimates and subject to interpretation.

22. Reflect on your market’s characteristics
You can then use the table to interpret the
characteristics of the market you will be
competing in. Once complete, you’ll be able
to answer key questions about your market!
Should I advertise a lot? And if so…do I
product differentiate?
Do I have pricing power or am I a price
taker?
Are my price changes dependent on
other firms?
Can I expect tough barriers to entry?